Detroit: Eligibility and Pensions

posted by Adam Levitin

Two big rulings in Detroit's Chapter 9 bankruptcy today: first that Detroit is eligible for Chapter 9 and second that it may impair its pension obligations in bankruptcy. Both rulings were delivered orally from the bench and transcripts aren't yet available, so it's hard to really parse them other than through selected quotations in the media. With that major caveat, here are my initial thoughts on each issue in turn:

(1) Eligibility. The eligibility ruling was no surprise. The issue seems to have turned on whether Detroit was truly insolvent and whether Detroit attempted to negotiate with its creditors in good faith prior to filing as required by statute for eligibility. For municipal bankruptcies, insolvency is defined not as a balance sheet test, but as an ability to pay debts as they come due. That seemed a fairly easy part of the ruling. As for the good faith negotiation, the Bankruptcy Code allows, in the alternative, that the debtor "is unable to negotiate with creditors because such a negotiation is impracticable". That appears to be the grounds on which Judge Rhodes found the good faith requirement satisfied (technically, it is an alternative to good faith).

As characterized by the NYTimes, Judge Rhodes's impracticability ruling was based on "the size of Detroit’s debts and problems" which made it impracticable to negotiate concessions from creditors, and Detroit's union creditors' reluctance to concede what they believed were rights guaranteed by the state constitution made it “impractical to negotiate with a stone wall".

If fairly reported, this seems like a reasonable enough analysis, but I wonder if it proves too much. Doesn't this mean that basically any city with lots of debts and problems doesn't have to make a good faith to effort to negotiate because it can shelter in the "impracticability" alternative? Isn't that the case for most debtors (and for most municipalities in financial distress)? If so, it would seem that the exception swallows the rule. Shouldn't impracticability have to rest on some other characteristic, such as a time window for negotiations that is too short for negotiations to actually occur? Impracticability surely can't mean the same thing as "it's tough" or "it's complicated." And maybe that's not what Judge Rhodes means, but that's my impression from the reporting. I suspect it will be hard to get this ruling overturned on appeal. I also suspect a lot will depend on the factual findings made by Judge Rhodes to support his conclusion, but at this point, I just don't know what those were.

(2) Pensions. Judge Rhodes also ruled that Detroit could impair its pension obligations. This is huge--it's a much bigger deal in general than eligilibity because this is the game for Detroit and for other cities that are watching in the wings. If Detroit can shed its pension obligations in bankruptcy, then bankruptcy enables municipalities to slough off decades of promises made to their employees. It also gives municipalities a lot more bargaining leverage outside of bankruptcy. Chicago has already been (arguably illegally) squeezing its municipal retirees on healthcare benefits now that a settlement has lapsed. Some municipal retirees saw their health insurance contributions rise 50% this past year, and more cost increases are on the way next way. The Detroit ruling is only going to embolden Rahm Emanuel.

Judge Rhodes noted that “Pension benefits are a contractual right and are not entitled to any heightened protection in a municipal bankruptcy". Well, yes, that's true, generically, but there's an added twist in this case: the Michigan state constitution prohibits the impairment of those pension benefits. The question, then, is what, if any, effect this state constitutional provision has in bankruptcy. One view is that the Supremacy Clause of the federal Constitution answers the question--to the extent state law conflicts with federal, it must yield. Arguably there is a conflict between the state constitutional provision and Section 901 of the Bankruptcy Code, which incorporates into Chapter 9 section 1123(b) of the Bankruptcy Code, which authorizes a bankruptcy plan to "impair or leave unimpaired any class of claims..." and this provision is subject to section 1123(a), which requires designation of classes of claims and specification of their treatment, "[n]otwithstanding any otherwise applicable nonbankruptcy law". If so, the state constitution doesn't affect bankruptcy. It might be interpreted, however, as making the State of Michigan a guarantor of all public pensions. Probably not what the state government wants.

On the other hand, Article 9 can be understood as being the result of a the federal and state governments bargaining as co-equal sovereigns and a rare example of where the Supremacy Clause does not apply. If this view is correct (and I think there's historical support for it--we'll see if the article ever gets finished), then it makes sense to permit states to condition Chapter 9 bankruptcy. Given that states are allowed to control whether municipalities can file for Chapter 9 in the first place, it would be strange if they could prohibit a filing, but not condition it--the greater should include the lesser.

None of this is going to get resolved in a blog post, but this is the sort of argument that is likely to have much more traction with a court of appeals than with a bankruptcy court, which is going to be reluctant to trim its sails in deference to the theoretical peculiarities of federalism when it has a real debtor with real problems before it. All of which is to say is that the pension issue in particular is far from decided at this point. Judge Rhodes' opinion was simply the kickoff for a much bigger fight.

Re negotiations being impracticable - the city pointed out in court that the municipal unions could not negotiate on behalf of the retirees (just current employees). And the ad hoc retiree committee formed early this year also had no authority to negotiate pensions. Thus Detroit would have needed to negotiate with tens of thousands of retirees individually.

Adam, isn't there a more direct and well-established way that the Michigan state constitutional provision gets into the bankruptcy case, namely that property rights in bankruptcy court are defined by state law? Isn't it just Butner and all that? I don't see why we have to get involved with esoteric constitutional theories of sovereignty (always to be avoided). Not I am not suggesting that Butner prevents the lowering of the pensions, just that it seems the more direct route analytically.

1. I heard pensions are expected to be paid at about 15 cents on the dollar. So a pension formerly worth about $20,000 per year will now be worth abut $3,000 per year. Most police and fire pensioners are not in the Social Security system from their work for the City, either.
2. Appeals in Detroit go to the District Court, not the BAP, though this case is clearly headed to the Sixth Circuit, and the loser(s) will be seeking cert. District Court Chief Judge Rosen has been working with other bankruptcy judges from around the country to try to mediate some of the more difficult issues in the case.
3. This can't help former Mayor Kwame Kilpatrick at his upcoming restitution hearing in the District Court.
4. I've always thought the state constitutional provision about pensions made the state a guarantor of their payment. I heard Gov. Snyder on the radio this morning, expressing the possibility that the state might take over management of the Detroit pension fund. He wasn't asked about the state making up the shortfall, however.

Posted by:
As a note to Christopher--the lead story on the Canadian Broadcasting Corp. National newscast last night was the Detroit bankruptcy, and Windsor's need for a strong |
December 04, 2013 at 10:40 AM

In reply to Bob Lawless, I would think that pension funds owed money by the city will be paid 15cents on the amounts owed to them. The pension funds themselves still have considerable assets, although nowhere near their liabilities due to the City's borrowing from the pension funds, so I would expect pensioners to receive nearer 50cents of their expectations.

If Judge Rhodes is correct that the Bankruptcy Code trumps state law governing pensions the next question is whether pensioners have a constitutional property interest in their pension contract with Detroit.

I can see how 365 lets Detroit reject labor contracts because those are clearly executory as Bildisco v NLRB recognized.

However, a contract for money (owed by Detroit) that is only fully performed by one party (the pensioner) is not executory.

But even this misses the constitutional question because ultimately the unsecured claim must be addressed.

What then would be “just compensation” for the “taking” of a pensioner’s contract?

I realize that it is not entirely settled that a party even has a constitutionally protected property interest in their contracts - inside or outside bankruptcy.

Anyway, Judge Rhodes can confirm Detroit’s plan if the plan is “in the best interest of creditors” and “feasible”.

Is satisfying these conditions the same as satisfying “just compensation” under the Fifth Amendment?

Doesn’t the lack of a provision allowing unsecured creditors to vote on a chapter 9 plan heighten the constitutional requirement to protect those creditors’ interest in their property?

Chapter 11 Courts frequently roll over these issues without concern.

Or is a chapter 9 more like a chapter 13 in that individuals get to impair unsecured claims up to the amount of exemptions necessary to support a minimal standard of living - ie., consumer debtors only get to impair debt up to what would NOT constitute a debtor’s “just compensation” of the creditor’s constitutional property interest in the amount owed.

Is a city a special class of debtor, like a consumer debtor with minimal needs that trump the Fifth Amendment and whose rights trump the rights of pensioners/creditors?

Due to chapter 9's sparse phrasing and minimal conditions these constitutional issues might be less defined under chapter 9 than elsewhere under the Code and therefore invite (and require) more principled consideration.

First of all, for some of the commenters, the 15% recovery only applies to the unfunded portion. The funded balance is untouched by the bankruptcy. If for example, the pensions have a 40% funding deficiency, then the pensioners will get 66% of their pension - 60% funded + (.15 * +.4) (all this being an actuarial calculation, keep in mind and actual returns may vary).

Second, on the ability to impair the pension, the relevant language in the MI Const is: "The accrued financial benefits of each pension plan and retirement system of the state and its
political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby." Note the "thereby". Under federal bankruptcy law, the city does not impair the pension, the plan of adjustment confirmed by the Court does. Detroit does not and cannot itself impair the pensions; rather it is petitioning the court to use the court's power under federal law to impair the pension - precisely because Detroit itself is in a trap and cannot get out of its own accord. In that respect it is just like any other debtor. It has made "a contractual obligation" that it cannot perform and state law provides no mechanism to relieve it of that obligation; recall that Art I of the US Const says States cannot impair Contracts. That protection applies to all contracts, not just public pensions. There is nothing unique about the pensions in this respect vis a vis the bankruptcy law. Once a state entity signs a contract to pay out money to someone, pensioner or anyone else, it has no ability to get out of that without the payee's consent so it must resort to fed bankr law.

The only reason the MI Const was even an issue was because the pension advocates were trying to say that the language I just quoted rendered Det ineligible to file (or was filing in bad faith) if upon filing it sought to propose to impair the pensions. Once you decide it's eligible and not a bad faith filing, the pension is just another "contractual obligation" and the issue disappears analytically because the federal court order is the one that impairs the pension contract.

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